Sunday, June 15, 2014
6:07:28 PM EDT

Unexpected Headlines

by
Jim Brown

I said last week, "The economic calendar is light and there is nothing on the geopolitical scene that should roil the markets. Of course those geopolitical events are never telegraphed in advance. They just show up unexpectedly and investors pay the price.

The ISIS attack in Iraq is a perfect example. While military analysts were watching the buildup and trying to decide what would happen the general public was blissfully unaware until it jumped up and bit us on Wednesday. The violence and the speed of the gains was a shock to the Iraqi government and to the administration in Washington.

Somehow just over 2,000 terrorists managed to take over multiple cities, loot the banks and begin an assault on Baghdad in less than a week. The Iraqi military stripped off their uniforms and blended into the crowd rather than fight the ISIS. The reason is the age old Sunni-Shia rivalry and the corrupt government in Iraq. The Shiite government was ignoring half the population and promoting sectarian hostility against the Sunnis.

The ISIS or ISIL depending on who is reporting, knows it can't take over all of Iraq but it can take over the Sunni-dominated provinces of Anbar, Ninawa and Salah ad Din. Possible they can also control the mixed provinces of Kirkuk and Diyala. They know America and its allies are not going to send in troops. They know the Sunni troops in the Iraqi army are not going to fight them. This gives them a brief window of opportunity to seize ground and demand a seat at the bargaining table with the Iraqi government.

What we are seeing is a further swelling of the Arab Spring that started in 2011 and it has the potential to redraw the boundary lines all across the Middle East. The borders of Iraq were drawn up by the British ages ago based on geographic features not the population within. There are three major areas in Iraq. The Kurds have seized control of the northern portion of the country and once fighting broke out this week they swiftly took advantage of the situation to seize the oil facilities in the north. The Sunni occupy the majority of the center of the country and the Shia occupy most of the south. It is entirely possible we see Iraq divided into three countries with each group responsible for governing themselves. The ISIS is also likely to get part of Syria where it now has control.

The wild card is Iran. They sent Revolutionary Guard troops to fight with the Shia government of Prime Minister Nouri al-Maliki. It is possible Iran ends up with control over the southern part Iraq and the oil fields and export terminals.

Iraq exports about 3.5 million barrels per day. The violence has not reached the southern oil fields and is not expected to reach that far. You simply can't control a country with 2,000+ fighters. The most likely scenario is that American air power will be used to pinpoint the leading edges of the insurgents and take them out. That will break the back of the attack and everything deescalates into a holding pattern and a Monopoly Game of country wide proportions begins. Eventually there will be a settlement and everybody get something and the ISIS consolidates its gains.

The ISIS has instituted a very severe form of Sharia law in the area it has captured. Refugees are fleeing by the thousands from these areas. More than 300,000 fled ahead of the fighting into Baghdad and reportedly more than 800,000 had previously fled.

Why does all of this impact our markets? First there is the fear the U.S. will get drawn back into a conflict it can't win. Despite what you hear on TV this is a sectarian civil war between Sunni and Shia that was sparked by the corrupt Shia dominated government of Nouri al-Maliki.

Secondly, there is the question of oil. If Iraq were to slow or halt its exports of 3.5 mbpd it would create a temporary crisis in the oil markets. That is about 4% of the world's supply. Given time Saudi Arabia could pump an extra 2.0-2.5 mbpd and other OPEC members could add a little extra but the price would jump significantly to something in the $125 range according to analysts. Oil companies are already moving their people out of Iraq even though the fighting is well away from the oil fields. They can't afford to put their people in danger and it could be sometime before it is safe enough to bring them back into Iraq.

The U.S. imports about 4.0 mbpd of OPEC oil. None of it comes from Iraq. This shows how unstable these Middle East countries are and why we should not depend on them for our oil. Currently Nigeria, Libya, Sudan and Venezuela are all undergoing civil strife and about 3.5 mbpd is off the market as a result.

This is a prime reason we should not allow U.S. oil to be exported to other countries. We currently import about 7.5 mbpd. Why would we want to export out light sweet crude and import sour crude from OPEC nations? Why should we continue to put ourselves at risk and put money into the pockets of countries that hate us? Sorry, I got off on a rant there.

For every $10 rise in the price of oil we lose -0.2% in GDP. With our economy growing at a 2.5% rate the sharp rise in the price of gasoline heading into the summer is going to further weaken the already stressed consumer. With gas prices currently at $3.65 nationally we are already closing in on that consumer threshold of $4.00 where wallets slam shut and consumers stay home. For every dollar increase in crude oil the price of gasoline rises about 2.5 cents. With oil up over $5.50 in the last week that is about 15 cents in gasoline rate hikes coming our way.

The Iraqi headlines are going to fade. The markets actually closed positive on Friday when in theory they should have sold off on worries of some new Iraqi headline over the weekend. The unexpected geopolitical event is behind us even though the civil war is going to continue. From this point forward it will be relegated to the inside pages and the impact on our markets is going to fade. However, if the oil production and export is threatened we could see another round of headline related declines. I don't expect it because the oil fields are too far south.

The Fed heads are going to have a lot to talk about at the FOMC meeting next week. The economic reports have been mixed and the spring snapback in activity is not as hardy as analysts expected. Inflation indicators have also been mixed.

The Producer Price Index (PPI) showed a -0.2% decline in prices for both the headline number and the core rate. Inflation was up sharply in the prior two reports at +0.5% and +0.6% so this may have just been an averaging out of the order flow. In the four months prior to March the inflation rate in producer prices averaged only +0.025%. Obviously the spikes in March and April were more than likely a snapback in demand after the severe weather. Now that is behind us so we are back to what has been a normal rate for the last year.

It would be hard for the Fed to get concerned about inflation at the producer level just because of two months of abnormal gains. Inflation is still nonexistent and there is no worry for the Fed on the rate front. This week we will have the Consumer Price Index (CPI) and see if any of those producer costs made their way into consumer prices. The CPI also spiked +0.3% and +0.2% in the prior two months after being nearly flat for the prior year.

Consumer Sentiment for June declined for the second month from 81.9 to 81.2 after hitting a high of 84.1 in April. The present conditions component rose from 94.5 to 95.4 but the expectations component declined from 73.7 to 72.2. Worries over rising prices were blamed for the decline in the expectations number. With the prices for meat, dairy and gasoline rising sharply it is impacting consumer budgets. Unfortunately food and energy are not used for calculating rising inflation. These "volatile" components are left out to provide a smoothed set of components for the inflation calculation. Since the majority of consumer's budgets other than housing and utilities are for food and energy I think the headline number is bogus.

The estimate miss on the headline number was the most in 18 months. This is not encouraging since we are supposed to be in the snapback period analysts have been promising.

The big events next week revolve around the FOMC meeting. This is the end of quarter meeting where they publish their economic forecasts and Janet Yellen will hold a press conference at 2:30. The FOMC meeting is always good for some extra volatility and the press conference is even better. However, every time Yellen has spoken she has boosted the market with her super dovish comments. Eventually she will realize there needs to be balance and the first time she tries to interject some uncertainty the odds are good she will over compensate.

The Fed forecast could also be volatile. While they rarely if ever get it right when it comes to predicting the future they were pretty bullish last time around or at least as bullish as the Fed can be. With the mixed economic reports and the downward forecast revisions by the IMF and the World Bank it will be interesting to see if the Fed heads lower their expectations. Several of the presidents are still looking for 3.5% growth or more later this year. Good luck with that!

The Philly Fed Manufacturing Survey on Thursday is probably the next biggest event for the week. This is the first major regional report for June and a proxy for the other Fed regions. The headline number is expected to decline from 15.4 to 14.0 making any number below 14 a potential market blip.

The NAHB Housing Market Index and New Construction will be of interest because of the declines in activity over the last six months. Traders will be hoping for a snapback in activity now that spring is here.

I am surprised the market did not implode on Friday. Not only was it Friday the 13th but also a full moon. Couple that with the uncertainty from Iraq and we should have dropped like a rock. I know there are studies that show humans act strangely around a full moon but I am not a advocate of applying that to investing. I prefer to think investors buy and sell for more rational reasons but then applying rationality to the stock market is questionable at best.

Volume was low again but all summer Fridays for the next two months are probably going to be even lower than the 5.07 billion shares traded on Friday. It is a pretty good bet we are going to have some numbers in the low 4 billion range.

Intel (INTC) was a major positive for the Dow with a $2 rally after the company raised its forecast after the close on Thursday. The Intel gain was worth about 18 Dow points. Intel said full year revenue was not expected to increase slightly compared to prior guidance for revenue to be flat. It was not a particularly glowing upgrade but apparently it caught the shorts off guard.

Professional analysts believe the boost came from the expiration of support for Windows XP rather than a sudden desire to buy new PCs. When Microsoft ended support for XP it meant the virus updates and newly discovered faults that let hackers exploit your resources were no longer going to be fixed on a routine basis. Corporations did not want to wake up one morning and find out an XP system had been hacked and 20 million credit cards were now floating around the web. Windows is two generations past XP and that support problem was all corporations needed to pull the plug on those remaining antique PCs.

Analysts were split on whether the XP buying cycle had completed or would continue for another quarter. Some felt it would last the rest of the year and others said it was over and recommended taking advantage of the $2 bounce in Intel to sell the shares. The FBR analyst said at least 25% of the PCs on the Internet were still using XP. That is a lot of hardware. IDC said XP replacement activity should remain "a positive factor for a few more quarters." However, IDC also said PC shipments would decline -6% in 2014. PC shipments have declined for eight straight quarters.

I would think the XP upgrade cycle would be more positive for Microsoft than Intel. Not only will they sell a new version of Windows but they will also sell a new copy of Office and probably a few more copies of SQL and various other programs. I just upgraded from XP about 6 months ago and my wife is upgrading now. I know how expensive it is to upgrade all that software.

Intel rallied to $30 and a 10-year high. Microsoft is holding at a 14-year high.

Open Table (OPEN) scored a huge reservation when Priceline (PCLN) logged in to buy the company. Priceline must have had too much to drink with their meal because they paid a whopping $2.6 billion or more than $760 million more than Open Table's market cap the day before. Granted there is always a premium but that is a 40% premium. That is a heck of a tip. Priceline is paying $103 per share in cash and shares closed at $104.48. Am I missing something here? Are investors expecting a competing bid? If so, who would it be?

Actually the deal makes sense because Priceline supplies customers to 425,000 hotels worldwide and Open Table only serves 31,000 restaurants in 6 countries. Priceline travelers are also eaters and since they are away from home the odds are good they are looking for a place to eat other than their hotel. It was a match made in reservation heaven.

Priceline shares fell -$37 or -3% on the news.

International Game Technology (IGT) soared for the second time in a week after it was learned that a number of new bidders appeared in the auction. IGT put itself up for sale and apparently the bidders are getting in line and it could be a seller's market. New bidders included GTech SPA, a giant lottery operator and Ron Perelman's MacAndrews & Forbes Holdings Inc. Apollo Management and the Carlyle Group LP are also bidding. Morgan Stanley is handling the sale and I think it is safe to say it will go for a premium.

Karyopharm Therapeutics (KPTI) had a really, really good day. The company announced a 50% response rate for patients with multiple myeloma treated with Selinexor and Dexamethasone. The press release was very technical and over my head but investors seemed to like it. Shares of KPTI spiked +93% to $47. That is a heck of a wakeup call.

Blackberry (BBRY) keeps trying to reinvent itself and this time with a mobile payments system. The company signed a deal with EnStream LP to provide a secure platform that supports transaction services between leading banks and consumers. According to Gartner the total value of transactions using mobile technology is expected to grow from $35 billion in 2012 to $173 billion in 2017. That is a huge market if Blackberry can get a platform running in time. Blackberry has been challenged with getting ideas to market in a timely fashion.

CEO John Chen also said Blackberry may introduce a phablet (large screen phone) in the near future. This also needs to come to market ASAP before the craze wears off. They are also planning on releasing a new non-touch screen phone called the BlackBerry Classic for those customers that refuse to give up their keys. They also have a medical phone in the works for doctors. This will display information about the patient gathered from linkage to diagnostic equipment and be capable of forwarding that information to other doctors for consultations.

Tesla CEO Elon Musk finally revealed his controversial news on patents. He said he would let anyone "in good faith" use his patents for free to further the electric car industry. He said he has met with BMW over using his rapid-charge system and he recommended BMW build its own battery factory. The lack of batteries is going to restrict any new entrants into the electric car field. The battery cost is 40% of the car's price.

If Musk can entice other manufacturers to use his patents and build their own compatible charging stations then the use of electric cars would rise and everyone would benefit. Tesla has more than 160 patents on their technology and they are on track to have more than 1,000.

Shares of TSLA have been range bound for the last couple of weeks at just over $200.

Russell announced the rebalance of their indexes to be conducted at the close on Friday June 27th. This happens every June. They review the weightings of each stock and re-rank them within the various indexes. Typically there is money to be made by watching the stocks being added to the indexes. With $7.5 trillion in funds indexed to the Russell indexes that is a lot of money that will flow out of the deletions and into the stocks being added. See the list of additions here.

There was a major selloff last week as the melt-up cooled off. How major was it? The S&P declined -16 points from its high close at 1,951 for a whopping decline of -0.8%. That is right. The S&P has not even lost 1% since its high close. That makes it really hard to call it a selloff when it is really just a hiccup. The trend is still intact and it is unlikely the Iraqi conflict is going to cause a much larger selloff.

The S&P showed that traders were taking profits but they were in no hurry. So far this is just a garden variety consolidation and there is plenty of support in the 1,925-1,920 range. We closed at 1,935 and support was only tested for a brief moment. We can't build a bullish or bearish case from three days of minimal declines. If I had to pick a direction I would expect the dip to be bought and the news out of Iraq will be positive by Monday. The high velocity attack by ISIS caught Iraq off guard but the Shia population of Baghdad is readying for the fight and that city is much better defended than Mosul. I expect the news to either soften or turn positive and the S&P should rebound on Monday. The positive close on Friday was a clue that others are thinking the same.

For the Dow the decline was a little sharper. After touching 16,970 on Monday the low for the week was 16,703 or roughly a -270 point drop before rebounding slightly on Friday. The Dow is now -230 points below that psychological 17,000 level and it should take several days to recover that lost ground.

The stocks responsible for the majority of the Dow's decline were WMT, HD, DIS, BA, T, DD and MCD. Boeing got a whopping $7 billion order from China on Friday so they should be up next week. WMT, HD, MCD and DIS are consumer spending problems and there may not be an easy fix.

On the positive side the financials, energy stocks and biotechs were positive. Despite the big decline in the Dow the damage was still minimal. The support range from 16,600 to 16,700 should hold unless there are some new headlines.

The Nasdaq 100 ($NDX) has been weak since Tuesday when Apple shares began to decline into their post split depression period. In theory we could see Apple shares continue to decline into the $85 range but with so many analysts pounding the table on Apple's "cheapness" I doubt we will see the $85 level. I would be thrilled if we did because it would be a buying opportunity but I am not counting on it.

Resistance at 3,800 was rock solid and support should now be prior resistance at 3,750.

The Nasdaq Composite slammed into a resistance wall at 4,344 on Monday and it was downhill the rest of the week. That is a serious resistance band from 4,344-4,371 and just touching the lower limit prompted a decline.

Fortunately the drop was minimal and support at 4,300 held on Friday. The Composite lows only 0.25% for the week so we can't say it was a brutal selloff. It was barely a decline at all.

Like the Nasdaq 100 the Composite is suffering from the decline in Apple and on Friday the -37 point drop in Priceline also weighed heavily but the index still closed positive. I think that was a bullish sign.

Like the Nasdaq the Russell 2000 recoiled immediately when it touched the resistance at 1,180. The decline was not severe and i think it should be bought. After the sharp rally the prior week it was due for a rest.

I warned on Tuesday we should key on the low at 1,166 for directional guidance for the market. That low was broken on Wednesday and the RUT closed at 1,162 on Friday. The new number to watch is the intraday support at 1,156 on Thursday. If we move below that level it could turn into a long drop to 1,120. I am not expecting that today if the Iraq news improves.

To summarize I expect the news to improve in Iraq. That will take the pressure off the market and oil prices will decline. The next hurdle will be the FOMC announcement and Yellen press conference on Wednesday. If she remains the "Queen of the doves" then the market should continue higher.

Random Thoughts

QE is not over. The Fed is still buying $45 billion a month in treasuries and mortgage backed securities. The Fed is still supporting the market.

The Ukraine is preparing for its gas supplies from Russia to be cut off on Monday for nonpayment. Because of past due bills, reportedly about $4 billion, Gazprom said it would only deliver gas if it was prepaid. The company said it required $385 per 1000 cubic meters, which was $100 per CM more than what was previously agreed. Gazprom had set the new post invasion price at $485 and Ukraine said it absolutely would not pay that price. Ukraine offered $268.50 and Gazprom came back at $385. The final offer from Ukraine was $326 and it was refused. The government told regional authorities to prepare the energy sector for the halt in natural gas as of Monday.

The real spark for a future conflict is the gas transported across Ukraine. The UK Prime Minister has instructed the national regulator to revise "transportation tariffs" for Russian gas moving through Ukraine to Europe. If Gazprom can arbitrarily raise gas prices to Ukraine by 85% then the the Ukraine government feels it should be able to charge more for gas going to Europe to offset the Russian price hike. This is not going to end well.

In Iraq the ISIS/ISIL is trying to carve out an Islamic caliphate using parts of Syria and parts of Iraq. These are the Sunni occupied regions. In the map below the brown area is controlled by ISIS, green is control by the Kurds and tan areas are controlled by Shia.

The entire Middle East is fractured because of the varied populations of Sunni and Shia. Adjoining countries can have significantly different populations and the ruling party is not always in the majority. The Middle East countries are tribal societies and the two sects have been fighting for a thousand years.

The ISIS has issued new rules for everyone in the occupied territories. They claim "We are soldiers of Islam and we've taken on our responsibility to bring back glory of the Islamic Caliphate."

All Muslims in the city have been instructed to attend mosque for the five daily prayers. Any one of its members who breach this promise will have their hands cut off.

No drugs, no alcohol and no cigarettes

All shrines, graveyards and monuments will be destroyed

All women must dress in concealing clothing that preserve decency. Females should only go outside "if necessary".

This is why the ISIS advance is going to stop outside Baghdad. This is a picture of Shiite fighters deploying with their weapons on Saturday to halt the ISIS advance. The Ayatollah Sistani, the highest religious authority for Shiites in Iraq, said during prayers on Friday "It is the legal and national responsibility of whoever can hold a weapon to hold it to defend the country, the citizens and the holy sites." Thousands of men immediately signed up to defend the city.

AP Photo

The Baltic Dry Index ($BDI) is having a very bad year. The index was trading at $2,337 at the end of 2013 and it declined to $906 on Friday. This is the cost to charter a ship for a day to carry dry goods on one of the major trade routes around the world. The cheaper the price the more plentiful the ships compared to the number of cargo's being booked. This suggests the number of shipments is continuing to decline. As investors we want the index to rise to indicate an increase in worldwide shipping.

Russia is sending tanks and other heavy equipment to Russian separatists in Ukraine. This is a sharp escalation in the conflict that was thought to be cooling. Russia sent a convoy of three T-64 tanks, several BM-21 or Grad multiple rocket launchers and other military vehicles into the Ukraine over the last three days. The T-64 tanks are no longer front line vehicles for Russia but they are kept in reserve in southwest Russia. Satellite photos show them on the way to and entering Ukraine but Putin still denied they came from Russia.

Jeff Gundlach showed a slide in a recent presentation on the length of time for each reserve currency since 1450. The dollar is the world's current reserve currency. It has been since 1921 or 94 years. No currency lasts forever and the dollar is under attack as the reserve currency by Europe, Russia and China. Europe has the euro and it is widely used around the world for financial transactions but not yet equal to the dollar. Russia is trying to promote the ruble by demanding that everything be paid for in rubles but there is no hope because of the rule of law is lacking. Nobody will ever trust the ruble because the Russian government can change it on a whim.

China is rapidly building up a mountain of gold reserves and some think China could eventually announce a gold backing for their currency to give it global strength. If this were to happen it would go a long way towards knocking kind dollar off the reserve throne. If that ever happens we would be in a world of trouble. We get by with a lot of financial tricks in the government because dollar denominated debt is the world's debt of choice. If the dollar were to decline sharply the debt would go down in value. The Gundlach chart below is food for thought.

Barclay's has revised their estimate for Q1 GDP to -2% from the last release at -0.98%. Consensus estimates for the next revision have fallen from -0.8% to -1.6% so Barclays is not the only shop with a negative outlook. Analysts were united in the expectations for a monster rebound in Q2 with some expecting as much as a 4.0% to 4.5% quarter. That bloom has faded and the consensus for Q2 is now +2% growth but estimates are fading fast. Retail sales have been terrible, home sales slowing, manufacturing easing, etc. There could be some ugly earnings warnings over the next 2-3 weeks.

However, Bank of America just upgraded the earnings forecast for Q2 from +9.9% to +10.3%. Considering we only managed +2.1% for Q1 that is quite a jump. BofA Merrill Lynch said analysts are making more positive earnings revisions than negative for the first time in two years. Maybe there is hope for a recovery if these earnings predictions come true.

The defeat of Eric Cantor by a Tea Party could mean the midterm elections are about to get a lot more exciting. However, if the victory in Virginia turns into a tidal wave the market outlook will turn negative. Electing a bunch of strong conservatives is going to make the next debt ceiling battle in 2015 a nuclear conflict and the last two years of Obama's presidency could be rocky for the economy and the markets. This will be especially true if the Republicans win the Senate. It will be open warfare between the president and the House/Senate. Normally when the branches are divided and nothing gets done it is positive for the stock market. However, in this instance I believe it will be negative.

They say, "Don't short a dull market." This is a dull market. The S&P has gone for 37 days without a 1% daily move. That is the second longest streak in 15 years. The last time it was this calm was in January 2007 when it went 38 days without a 1% move. Since 1928 in an average 37 day period there are normally 9 days with 1% moves in either direction. There have only been 20 prior instances where the S&P went 37 days without a 1% move. (Data from Jason Goepfert)

The Monday of triple witching option expiration week in June the Dow has been down 10 of the last 17 years. Triple witching Friday in June has been up 8 of the last 11 years. However, the week after the June triple witching has been down 21 of the last 24 years with better than 1% moves very frequent. The average weekly loss is -1.1%. Past performance does not guarantee future results but I think we need to pay attention.

I updated the analyst forecast graphic with some revisions I received last week. Credit Suisse raised their end of year forecast from 1,960 to 2,020. RBC raised their forecast from 1,950 to 2,075. I found two additional estimates with Weeden at 2,100 and Canaccord at 2,185. NOBODY has revised their estimates lower so far this year.

The AAII sentiment poll showed bullish sentiment jumped from 39.51% to 44.69% and the highest level in 2014. That was the largest one week increase since late April. Extremely high bullish readings are considered to be contrarian indicators so keep those stop losses tight.

The top five market timers at calling turns in the stock market all expect the market to move higher. That is a real contrarian indicator for sure. Those are Nick Chase, Dan Sullivan, Jim Schmidt, Jack Schannep and Jeff Hirsch. They have the best records for timing the market over the last ten years. Jeff Hirsch claims the Dow will reach 19,000 in the first half of 2015. Jack Schannep claims all his preferred indicators are in buy mode.

Would you like to buy some Bitcoins? The FBI is auctioning off 30,000 that were seized as part of a crackdown on the Silk Road online marketplace last year. Actually it is 29,656.5130529 coins. Check out the Federal Marshall's website for info HERE

The FBI is watching numerous hackers invade our electrical and water systems to try and understand what they are looking for and how to stop them. They claim there are hundreds of intrusions every week and apparently they are military motivated from China and Russia and they are looking for ways to shutdown the systems and cause damage in the case of a conflict. Last week a hacker named UglyGorilla logged in to a utility in the Northeast and copied schematics of pipelines, security-guard patrol memos and sought access to systems that regulate the flow of natural gas. The FBI said he cruised through areas where a single keystroke could cut off a cities heat or make a pipeline explode. This particular hacker has been traced back to the Chinese military and appeared to be one of hundreds looking for ways to shutdown electricity in case of war. The FBI is monitoring hackers from China, Russia and Iran on a daily basis.

I want to thank everyone that responded to my email request last week. The response was overwhelmingly positive and everyone wanted to keep the Random Thoughts section.